Review of Akerlof and Shiller

I’ve been planning a post with reviews of lots of the books I’ve been reading, but haven’t got to it. So, I’m going to post a couple now, and try to get back to it later. Here’s a review of Akerlof and Shiller Animal Spirits

When starting a new book, it is often tempting to skip the introduction and get straight to the main body of the argument. That would be a mistake in the case of Akerlof and Shiller’s Animal Spirits. The crucial innovation of the book is described in the opening pages, where Akerlof and Shiller say

The economics of the textbooks seeks to minimise as much as possible departures from pure economic motivation and from rationality. There is a good reason for doing so – and each of us has spent a good portion of his life writing in this tradition. The economics of Adam Smith is well understood. Explanations in terms of small deviations from Smith’s ideal system are thus clear, because they are posed within a framework that is already very well understood. But that does not mean that these small deviations from Smith’s system describe how the economy actually works

Our book marks a break with this tradition. In our view, economic theory should be derived not from the minimal deviations from the system of Adam Smith [needed to provide a plausible account of observed outcomes] but rather from the deviations that actually do occur and can be observed.

Before returning to the critical implications of this idea, it is worth looking at the way Akerlof and Shiller use it. The book starts with five deviations from the standard model of rational maximization (confidence, fairness, corruption, money illusion and stories) and argue that some combination of these can be used to explain a range of economic outcomes inconsistent with the standard model.

The most immediately interesting applications of this idea are to the question of why economies fall into recession and depression, and what can be done about it. In addressing this question, it is natural to start with observations of the 19th century business cycle, before the development of active monetary and fiscal policies. Akerlof and Shiller look first at the 1890s Depression in the US, which they describe as the second-worst in US history, before turning the exception of the Great Depression.

As with conventional accounts, Akerlof and Shiller begin with the Silver Purchase Act of 1890 and the Panic of 1893. But, they argue, there was no rational reason for a government shift towards bimetallism to lead to a banking panic. Rather, they argue, that concern over the silver policy led to a loss of confidence, and experience of past banking panics led people to conclude that their deposits were at risk. Withdrawals generate panic, which further erodes confidence. This fits their more general account of a ‘confidence multiplier’.

To this fairly standard account, Akerlof and Shiller add a discussion of the cyclical growth and exposure of corruption, broadly in line with Galbraith’s idea of the ‘bezzle’ which they mention in a footnote. The ‘bezzle’ is the amount of undiscovered embezzlement or fraud in the system at any given time. It grows during boom periods when those who misappropriate money to engage in speculation can make profits sufficient to return the money before they are detected. As the boom turns into a bubble, the rewards to embezzlement increase and the bezzle grows apace.

But with the bursting of the bubble, companies go bankrupt, their accounts are opened for inspection, and embezzlement is exposed. The guilty (at least those who did not cash out in time) are punished, more stringent standards are imposed and the bezzle shrinks to low levels as the economy reaches the bottom of the cycle.

Akerlof and Shiller focus on the interaction between the exposure of corruption, inevitable with the bursting of a bubble, and the effects of declining confidence and loss of faith in fairness on ‘animal spirits’ in the economy. These factors then affect the kind of ‘stories’ people tell about the economy. In bubble periods, as Shiller has shown in previous work, stories about a ‘New Economic Era’ emerge in which prosperity will be unending and old-fashioned constraints, such as the need for careful accounting, no longer apply. In the 1890s, stories focused on the railroads and the opening up of the West. A century later, during the dotcom bubble of the late 1990s, the central role was played by the Internet, but the narrative was essentially unchanged.

Akerlof and Shiller add a new element to the analysis, looking at the fearful stories that circulate during periods of depression. This is the idea that in such periods, people will lose faith in the existing economic system and propose radical changes. Under such circumstances, owners of capital will be less willing to invest. Akerlof and Shiller cite both the bitter 1896 election campaign, and fears in the 1930s that the New Deal would lead to the end of capitalism and the adoption of a largely socialist system.

This analysis has some problems, particularly regarding the idea that the threat of radical reform discourages investment. Class conflict does not disappear, and is sometimes exacerbated, in periods of prosperity. And, in many respects, the likelihood of a shift towards socialism seemed even greater in the immediate aftermath of World War II (Hayek’s Road to Serfdom was published in 1944) than during the Depression.Yet despite a greatly expanded role for government, business investment boomed.

The defining feature of recession, for most people is unemployment. Here, Akerlof and Shiller present a fairly standard money illusion story, as to why workers resist money wage cuts. In addition, they argue that considerations of fairness mean that workers will resist having their wages cut when others have not experienced the same cut.

This analysis has some policy implications that are worth noting. Most obviously, to the extent that fairness is important, a centralised wage fixing system should do a better job than the decentralised plant-by-plant bargaining typical in the US. An obviously relevant instance is the Premiers’ Plan adopted in Australia during the Great Depression, which included across the board cuts in wages, pensions and interest paid to Australian (but not overseas) holders of government bonds, along with cuts in government expenditure. Evaluations of the Premiers Plan have differed widely, both at the time and subsequently. The adoption of the Plan was followed by a substantial economic recovery, but unemployment levels remained above 8 per cent throughout the 1930s. So, it seems as if more than real wage adjustments may be needed to bring the economy out of a low-employment equilibrium.

Arguably, the most important implication of money illusion is the existence of a Phillips-curve tradeoff between unemployment and inflation. Since, the expectations-based critique of Friedman and Phelps, the standard textbook view has been that such a trade-off exists only in the short run and that the long-run Phillips curve is vertical. Akerlof and Shiller present a variety of arguments to suggest that, for low rates of inflation (between zero and two per cent), there will be a significant trade off, with the reduction from two per cent to zero entailing a long-term increase in unemployment of 1.5 percentage points.

Although most textbooks maintain a vertical long run Phillips curve, the experience practice of central banks in the period of inflation targeting suggests that the Akerlof-Shiller viewpoint is widely accepted. Most central banks have adopted target ranges of 2-3 per cent and, as Akerlof and Shiller note, countries such as Canada and New Zealand that have chosen lower targets have mostly abandoned them as a result of poor macroeconomic outcomes.

One difficulty with the discussion here, and indeed with most macroeconomic discussions of inflation is that the index number problem associated with inflation measures is ignored completely. In an environment where the quality-adjusted prices of some durable goods, such as computers, are declining at 30-50 per cent per year, and the consumption of these goods (again, quality adjusted) is growing strongly, while most other prices are rising gradually, the range of inflation measures consistent with the Laspeyres-Paasche bounds will be very wide.

Given that households form their estimates of inflation from regular purchases of goods that are rising in price, and occasional purchases of goods that are becoming cheaper, their estimates of inflation are likely to be inexact. Inflation estimates are likely to be made on the basis of heuristics such as representativeness and availability, discussed by Kahneman and Tversky among others. An analysis of inflationary expectations drawing on such ideas would, of course, be entirely consistent with the approach espoused by Akerlof and Shiller.

And this brings us back to the big methodological question posed in the introduction: how will economics change if modelling of human behavior based on perfect or near-perfect rational optimisation is replaced or heavily modified by consideration of ‘animal spirits’.

One obvious implication will be to reduce the gap between economics, where rational optimisation is standardly assumed, and the other social sciences, where rational choice models of behavior are either absent or represent a minority view. This gap has been narrowing in recent decades. Economists modelling problems of choice under uncertainty and over time have adopted broader notions of rationality, such as generalized utility theories and models of hyperbolic discounting. In other social sciences, functionalist and structuralist models, where humans are modelled as passive bearers of social or class roles, have largely given way to frameworks in which humans are seen as undertaking purposive, if not perfectly rational, action in the pursuit of meaningful, if not always perfectly consistent, goals.

Even more significant are the implications for the style of economic explanation. The assumption that individuals maximize the lifetime utility derived from the consumption of goods and services traded in competitive markets forms the basis of a large and highly formalised body of analysis. As Akerlof and Shiller observe, much of the work of modern economics consists of modifying the assumptions of the standard model and deriving implications for the existence and characteristics of market equilibria. A crucial requirement, for work of this kind to be regarded as a valid contribution, is the maintenance of the same analytical rigour used in the derivation of the standard results, as represented, say, by the Arrow-Debreu theory of general equilibrium.

It seems likely that, in most areas of microeconomic theory, the demand for rigour will prevail. That is, the profession will prefer to develop sharp results on the consequences of limited deviations from rational optimisation rather than discussing more realistic representations of consumer psychology that do not have clear-cut implications for market behavior. This preference was evident in the Friedman-Samuelson methodological debates of the 1950s.

This prediction about preferences arises from the observation that, in most areas of application, neoclassical microeconomics is seen as an empirical success.As regards ‘standard’ markets for goods and services are few major anomalies seen as representing a challenge to the standard paradigm, From partial equilibrium estimates of the impact of tax changes to computable general equilibrium analyses of trade policy, neoclassical microeconomics is seen as providing answers that are good enough for policy work and better than any likely competitor.

The main exceptions to this pattern are in labour and asset markets, and, unsurprisingly, these are the areas where Akerlof and Shiller point to the importance of animal spirits. Wages are much stickier than theory suggests, while asset prices are much more volatile.

These are markets that play a major role in macroeconomic thinking, and indeed the biggest implications of the Akerlof-Shiller argument are for the ‘new Keynesian’ macroeconomic approach with which both have long been associated. The central theme of new Keynesianism was the need to respond to the demand, from monetarist and new classical critics, for the provision of a microeconomic foundation for Keynesian macroeconomics.

As Akerlof and Shiller note above, the research task was seen as one of identifying minimal deviations from the standard microeconomic assumptions which yield Keynesian macroeconomic conclusions, such as the possibility of significant welfare benefits from macroeconomic stabilization. Akerlof’s ‘menu costs’ arguments, showing that, under imperfect competition, small deviations from rationality generate significant (in welfare terms) price stickiness, are an ideal example of this kind of work.

New Keynesian macroeconomics has been tested by the current global financial and macroeconomic crisis and has, broadly speaking, been found wanting. The analysis of those Keynesians who warned of impending crisis combined an ‘old Keynesian’ analysis of mounting economic imbalances with a Minskyan focus on financial instability.

Similarly, the policy response to the crisis, which seems to be having some positive effects, has been informed mainly by old-fashioned ‘hydraulic’ Keynesianism, relying on massive economic stimulus to boost demand. The opponents of Keynesianism have retreated even further into the past, reviving the anti-Keynesian arguments of the 1930s and arguing at length over policy responses to the Great Depression.

There is of course, still a need to explain why wages do not adjust rapidly to clear labour markets in the face of an external financial shock. But, in an environment where the workings of sophisticated financial markets display collective irrationality on a massive scale, there is much less reason to be concerned about the fact that such an explanation must involve deviations from rationality, and seeking to minimise those deviations. Rather, as Akerlof and Shiller suggest, a sensible theory of wage determination should be derived from behavior that actually occurs and can be observed.

Undoubtedly, the time is right for a reassessment such as that proposed by Akerlof and Shiller. Although their book was written before the full extent of the crisis became apparent (it includes a brief, last-minute response), they have drawn on the lessons of earlier fluctuations to provide an analysis that seems far more promising than the elaborate macroeconomic models that failed to predict the crisis or even to provide an adequate diagnosis after the fact.

The shift towards a more realistic economics, based on actual human behavior rather than idealised notions of rationality, has been gathering pace for some time. Animal Spirits may become its popular manifesto.

Hi John, I’m a non-economist who has been reading a bit of economics out of interest thru the GFC. I read Animal Spirits and really enjoyed it. I’d suggest you add one thing to your review for non-economists like me. The background reason this book is so interesting (to noobs like me, anyway) is because Shiller was one of the few to correctly point out both the tech bubble and the housing bubble before they crashed. So his theories carry more weight for a reader like me – they aren’t just theories, they are the thoughts of a person who has used them to make interesting and useful predictions. Cheers, B

I don’t understand why sticky wage markets is a mystery? Psychologically I think we all have an expectation of wages rising through our life times, even though people might reach their peak in their 40s and productivity decline thereafter. Practically, I would think that most people with fixed financial commitments (home mortgages, debt repayments etc) will be reluctant to accept an actual cut in wages. The worst they would expect would be no gain. So it winds up being a bit like a school of fish with a shark circling – everyone hopes they are the one to cling to the their current job and conditions, and someone else loses theirs, rather than agree to a cut that will be painfull. We assume a degree of group think that does not exist in practice.

I have also always thought that economic expectations of the willingness of workers to redeploy to new industries was unrealistically high. The worker has invested in their own intellectual capital in terms of their work skills. If they move to another industry here that is of no use it is a substantial loss to them. Sorry if I misunderstand the point.

For the non-economists, though, it is important to take on board John’s point that the reason Adam Smith’s paradigm has persisted is not simply ideology or conservatism on the part of economists (though of course both exist), but extensive empiric success. Lots and lots of things can be very plausibly analysed, explained and predicted with perturbations of the neoclassical model.

So the reluctance to part with it is a problem of its success rather than its failure. It also remains to be seen whether in the long run Akerlof and Shiller’s “old Keynesian” approach has more practical use in prediction than alternatives. One empiric success does not a methodological revolution make.

I didn’t read anywhere that Smith was in dispute for micro-economics. Surely the problem is that at the macro level when things go wrong, Smith’s conceptualisation goes wrong too? So we do need something else to explain and direct in times like now. I don’t see why we need to choose between the two, just as in physics we know about relativity but can still use Newtons laws for most day to day applications. We do need a methodological revolution for the extreme cases. Adherence to one theory in the face of contrary evidence, does not a science make.

One of the interesting points in the review (and presumably the book) is that there the elusive “micro foundations” for Keynesian macro my lie in the market failures (a well known concept in microeconomics) inherent in capital and labour markets. As I understand it, Minsky provides some useful pointers to analysing capital market failures, but I think we’re still at a loss for a good economic explanation of labour market rigidity.

BTW, Professor Quiggin, have you listened to the podcast of Paul Krugman’s Robbins Lectures? I thought they were very good – and I’d be very interested in your take.

“in an environment where the workings of sophisticated financial markets display collective irrationality on a massive scale, there is much less reason to be concerned about the fact that such an explanation must involve deviations from rationality”

Isn’t this mixing up bad equilibrium outcomes (“collective irrationality”) with the question of individual rationality? It’s quite easy to tell a rational herding/assymmetric info/bank run story for why financial markets blow up.

Jim Birch – not necessarily, if “collective irrationality” just means a really bad outcome, this is perfectly compatible with individuals making rational choices (eg tragedy of the commons). Eg in finance performance related pay, information assymetries and bankruptcy constraints made giant heads-I-win-tails-you-lose bets rational. Equally, a bank run/”crisis of confidence” can also be perfectly rational at the individual level.

Perhaps, but also maybe not. That’s precisely Declan’s (and Minsky’s) point. It’s possible for the *individual* behaviour of all participants to be rational, at least given their limited knowledge of the future, while the *collective* behaviour is quite irrational. It’s a generalisation of the dictum attributed to Keynes that “the market can stay irrational longer than you can stay solvent”.

I see what you mean, but if we know that simplistically pursuing private goals will lead to a disaster aren’t we a bit stupid to do so?

The term “enlightened self interest” has been used in this situation, meaning that you are actually rational rather than impulse-driven. If your formal definition of rational behaviour includes a group march off a cliff then you’re probably not aligned to the conventional idea of rationality.

And doesn’t this quandry have an ideological slant? I mean, the idea that the best possible world must appear if everyone follows their self interested impulses is plainly crazy to me but there’s many who would argue it in one variant or another and consider it rational.

For the non-economists, though, it is important to take on board John’s point that the reason Adam Smith’s paradigm has persisted is not simply ideology or conservatism on the part of economists (though of course both exist), but extensive empiric success. Lots and lots of things can be very plausibly analysed, explained and predicted with perturbations of the neoclassical model.

I think Adam Smith predates the Neoclassical Model by about one hundred years.

To this fairly standard account, Akerlof and Shiller add a discussion of the cyclical growth and exposure of corruption, broadly in line with Galbraith’s idea of the ‘bezzle’ which they mention in a footnote. The ‘bezzle’ is the amount of undiscovered embezzlement or fraud in the system at any given time. It grows during boom periods when those who misappropriate money to engage in speculation can make profits sufficient to return the money before they are detected. As the boom turns into a bubble, the rewards to embezzlement increase and the bezzle grows apace.

But with the bursting of the bubble, companies go bankrupt, their accounts are opened for inspection, and embezzlement is exposed. The guilty (at least those who did not cash out in time) are punished, more stringent standards are imposed and the bezzle shrinks to low levels as the economy reaches the bottom of the cycle.

If you don’t know exactly where the cliff is – say you’re blindfolded, or there’s a heavy fog – and the penalty for not following the group is certain and painful, then yes, I think it can be rational, in the conventional sense, to group march off it.

Given that raw price and quality data is kept more secret by statistical agencies than nuclear launch codes, I wonder how can someone assert such a thing.

Very very few people in each country have access to raw price and quality data.

No one on earth has had access to two countries raw price and quality data (see OECD publications on this topic).

How can then people assert anything about inflation?

You mention a lot “confidence” in your post, but in the case of published inflation numbers you need faith not confidence. Unsurprisingly, many people have no faith in government economists published inflation.

Hopefully this is easy to fix, but economists seem unwilling for some reason to open their raw data to the public eye.

Individuals do not have to rely on statistics, published by applied (empirical) economists, working for governments or private firms. Individuals can form expectations about monetary prices on the basis of their private observations. It is corporate decision makers who tend to use statistical methods (projections) to form expectations (apparently to appear to justify their actions). The corporate form of enterprise does not sit well with a lot of economic theory and modelling.